Melinda McKay, CFA, an analyst at Integrity Equity, is considering an investment in Earthmovers Inc., whose most recent financial data is provided below. Earthmovers Inc. Income Statement Year ended Dec 31, 2006 ($U.S. thousands) Revenues 20,152 Gross profit 10,022 Operating income 4,819 Depreciation 823 Interest expense 1,040 Income before taxes 2,956 Taxes 887 Net Income 2,069 The footnotes to Earthmovers Inc. include the following information: „X Inventories are valued at cost under the LIFO method, the LIFO reserve is $1.2 million, up $120,000 from the previous year. „X Capitalized interest for 2006 is $550,000. „X Earthmovers recently sold $400,000 worth of accounts receivable with recourse. To date only $100,000 has been collected. What is the value of the times interest earned ratio (earnings before interest, tax, depreciation and amortization (EBITDA) / interest expense) using the adjusted data? A) 2.8. B) 3.0. C) 4.3. D) 4.6. Your answer: B was incorrect. The correct answer was A) 2.8. The income statement needs the following adjustments: „X Capitalized interest should be included on the income statement. Inclusion will not affect EBITDA but will increase interest expense to 1,590,000 (1,040,000 + 550,000). „X EBITDA should be reduced by $300,000 ($400,000 - $100,000) to $4,519,000 due to the sale of accounts receivable that are yet to be collected. Therefore, EBITDA / interest expense is 2.8 (4,519,000/1,590,000). MY QUERY - why should we make an adjustment for sales with recourse on the income statement… shouldnt we just increase CA and CL by 300,000 … thanks in advance…
I think you it is due to the fact that sales are overstated because you have not received the money yet. Thus this will effect you EBITDA by 300,000. can someone confirm please?
why does the inclusion of the 550,000 capitalized interest expense not affect the EBITDA but affect the total interest?
i had the same question on this one and still do not understand it?
Is it because the Capitalized interest is part of CFI so its not part of operating income, but the total interest includes all interest payments?
i picked B too …
capitalised interest doesnt affect EBITDA because EBITDA is before interest… Earnings before Interest, tax, depn and amortn… hence that part is correct… wonder 2008 - I was also thinking of your logic but then there is a second part to this question (which I have not posted here ) , where they reduce 300 thousand from CA and CL… and I did the same and got the correct answer for current ratio… so then isnt it that there is a double effect been given?
you are reducing Assets because you will not be receiving the accounts receivable and liabilities because now you have less recourse… do you agree?
I completely agree on that aspect hey sorry… they had added back 300,000 to current assets and current liabilities… added to CA because, we stil have accts receivable … and increase CL by the amount received from the sale… since it is with recourse it is treated like a short term loan… but since the credit and debit effect is given, why the third effect of reducing EBITDA ?